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The impending Basel II capital adequacy rules will have profound impacts for corporates looking for bank funding or trade finance, so it’s best to start preparing for these new rules now.

The impending Basel II capital adequacy rules will have profound impacts for corporates looking for bank funding or trade finance, so it’s best to start preparing for these new rules now.

The simple answer is that using banks will become more expensive and there will be less choice, after Basel III is introduced, particularly as regards international services. Basel III tightens the screw on banks in three ways:

  •  Imposing the holding of a larger block of capital as a percentage of risk-weighted assets (meaning all transactions involving credit, market or operational risk, whether they are on-balance sheet or not). The percentage rises from originally around 4% to 10% and banks will want to earn a wider interest margin in order to attain their Return on Equity (ROE) target;
  •  Increasing the risk-weighting on all transactions, reversing the endemic and self-certified under-weighting through the 1990s and 2000s, when OECD sovereign risk and exposure secured on real estate (retail and commercial) enjoyed low weightings ; since proven to be flawed. On this measure again, banks will need to hold more capital against each loan and so must earn a wider margin in order to have the same return;
  •  Imposing visible costs on short-term deposits, which are deemed “unstable” and for which the bank will have to hold a percentage on a low-      or nil-interest bearing account at the central bank. These deposits then form a fund for the central bank to deal with a run on any one bank, and they reflect regulators’ unease about institutions that depend on wholesale funding (i.e. that no lessons were learned from Continental Bank of Illinois’ demise in 1984).

On the asset side of the bank’s books the bank will want more money to pay for the increased capital. On the liability side it will pay less on deposits because the deposits cost the bank more to hold.

In other words the customer will have to pay a higher parking fee for putting its assets and liabilities on the bank’s balance sheet, as opposed to finding non-bank investments and non-bank sources of funding.

Basel III – Too Much, Too Late

A study of 58 major banks in early 2011 by Independent Credit View, a Swiss rating company, concluded that banks may have a capital deficit of more than $1.5trn at a time when capital markets are unreceptive to new issues, while existing shareholders are reluctant to take up new issues that represent massive dilution.

The European Banking Authority’s (EBA) stress test of 100 European banks required a plan of each bank to reach the 10% target: only UniCredit proposed raising new share capital. Nevertheless, the EBA approved all the plans – wrongly concluding that achieving them plan would not reduce EU money supply and cause a depression. The EBA concluded this because the plans showed a reorganisation of balance sheets via the sale of non-core assets.

An example would be Barclays’ disposal of 20%+ stake in BlackRock: the planned sale will indeed reduce Barclays’ gearing but the guideline sale price is US$1bn below book value. So Barclays might well reduce assets and liabilities via this sale but it would directly deplete capital by US$1bn, although at least BlackRock might attract interest from insurance, fund management and investment organisations.

The EBA’s delusion stems from a failure to recognise that a bank’s non-core assets are still financial services industry assets and only of interest to another FS industry buyer: if all 100 of the top banks are sellers, who are the buyers? It’s a buyer’s market certainly – but in the absence of any buyers the replenishment of capital cannot occur through sale of non-core assets. Instead it has to be via shrinkage of business and increased revenue on what remains.

Increased Revenue 

The obvious and immediate outcome is wider interest spreads on short term business, meaning firstly wider overdraft and loan margins to pay for the higher capital allocations and then lower rates on deposits to absorb the costs of liquidity reserves.

A key question is whether corporate and institutional current account balances, as opposed to time deposits, get computed into stable funding or not. If they are, then there will be even hotter competition for this kind of business. If they are deemed unstable, there will be a high cost to the banks that accept the money.

Narrower Customer Targeting and Smaller Credit Lines 

The second reaction will be for banks to shrink the target market to house clients and to de-emphasise foreign clients where it is not top-tier, and also to concentrate on ‘home markets’ i.e. markets where the bank can achieve sustainable market share and profitability from that market alone.

Then it is a reduction of the amount of credit per customer group, de-emphasizing types of business that require large but often unutilised lines; especially if they are uncommitted and attract no commitment fees, and cause the bank’s notional exposure to get towards the legal lending limit.

Impact on Banks’ Overseas Networks

The changes described above will have a marked impact on international services and overseas networks, few of which will qualify as sitting in home markets. An early effect will be a reduction of the fishing right, available to local marketing staff, to add local business that is not connected to house clients or home markets.

That would, in turn, affect the syndicated loans market in a location like London:

  •  Fewer banks with an overhang of liquidity out of their home market, looking to invest that liquidity in loans regardless of whether the borrower is a house client or not;
  •   An illiquid interbank market underlying loans that are usually priced off the London Interbank Offered Rate (LIBOR);
  •  A thinner market as traditional players ‘fold their tents’;
  •  Greater difficulty in achieving consensus on the right margin for a certain loan, given the increasing diversity of banks’ capital adequacy positions and pricing models.

Without a syndicated loan market to participate in, the rationale for a number of banks’ presences in London (for example) may dwindle. In turn, these and other overseas operations are likely to figure in the list of non-core assets that were shown to the EBA as ready for sale. The policy from head office would tend towards focus and shrinkage, inhibition of local initiatives and so on; by implication that reduces the sale value of the asset, effectively Hobson’s choice.

No Future for Branch Networks as Bought-Money Banks 

A bought-money bank is one without a retail deposit base. It is the kind of operation that the rules around unstable deposits will hit hard. Foreign branches have traditionally funded themselves with local interbank deposits in order to meet the credit needs of subsidiaries of ‘house’ clients. Foreign branches (other than Icesave and ING Direct) have not been established to bring in a deposit base.

That has to change. If the foreign branch is asset-driven and just a lending office, its net interest income will be squeezed from both sides.

Managing Bank Relationships 

Corporates will inevitably find that they feature in the target market of fewer banks. That will include fewer foreign banks through their operations in the corporate’s head office country. Foreign banks may simply have no division focussing on what are, for them, foreign corporates, or else that function will move from the local branch and back to head office.

For the corporate this could simply mean more travel, or a great difficulty in finding banks that will both offer local banking services and look beyond the size of the subsidiary to the size of the parent when it comes to size of lines and the terms and conditions.


Basel III raises the costs of doing business with banks, and banks’ reactions will not be limited to raising charges. They will extend to:

  •  Narrowing the customer target market
  •  Focusing on certain lines of business
  •  Offering services over a narrower geography

Less profitable activities will be curtailed. A customer should assume that a bank will take them on as a customer. And banks generally will de-emphasise their foreign operations, because they will have less scale and sustainability, and because there will be political pressure to focus resources on home markets.

The advice to corporates has to go beyond clichés like “investigate non-bank alternatives” and “optimise order-to-cash” and to have a genuine relationship management approach towards the banks that supply the major part of credit. Corporates are doing that already.

Could the advice include an approach to bank and non-bank investors in the Middle East and Far East? How likely is the corporate to fall into their investment criteria there, if the borrower does not already tap non-bank markets in Europe and North America?

For the corporate that relies mainly on banking funding the advice should include:

  •  Identify retail banks with deposit bases that are willing to offer commercial banking services to group subsidiaries.
  •  Devolve relationship management with those banks back to the subsidiary level from the group treasury level.
  •  Actively identify banks whose business structure is less harmed by Basel III, and ones that have meaningful international cooperation agreements with similar banks.

This could be perceived as counter-cultural; representing a step back from centralisation and a reduction in the number of bank relationships. But then the central, wholesale market has become illiquid, so a borrower is best advised to track back to the original source of funds.

 Link to GT News, June 2012 article online